Income Annuity: Pros and Cons of Predictable Income

By Markets Fool.com

An income annuity is all about predictable income. In exchange for a lump-sum payment, an immediate annuity will pay you a fixed amount of money every month, typically for as long as you are living.

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Whereas you buy life insurance to protect from the risk of dying young, an annuity protects against the risk that you live too long and outlive your savings. The amount of money you receive in exchange for your investment varies based on three factors: interest rates, your investment amount, and your current age.

Income annuity returns

When interest rates are low, as they are right now, annuity payments are also lower. This is because the insurance company backing the annuity will only earn a very small amount of money by investing the proceeds of your lump sum payment.

Your age also plays an important role in your annuity income. A typical annuity is a so-called "single life" annuity that pays until the death of the buyer. Naturally, people who are younger are expected to live longer, thus collecting more payments, so each payment is smaller. Those who are older will receive larger monthly payments, due to the probability that they do not live to collect as many payments.

Thus, logic follows that females also receive smaller monthly payments than males, because women have much longer life expectancies.

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Estimated monthly income from a $10,000 income annuity is as follows:

Age

Male

Female

60

$479

$466

65

$538

$517

70

$622

$589

75

$752

$698

80

$922

$867

Data source: Recent quotes from an annuity aggregator.

Pros and cons

The biggest advantage of buying an income annuity is that you can more confidently spend the income you earn from your retirement savings. Because an annuity is guaranteed to pay for as long as you are living, you can be confident that you'll have a baseline source of monthly income during retirement.

Consider this: A 76-year-old American man can currently expect to live about 10 more years. However, it would be imprudent for him to divide his savings by 10 and spend a tenth of his current savings each year. There is a very good chance he lives much longer. It's quite possible (28% probability) that he lives to see his 90thbirthday!

By purchasing an income annuity, this 76-year-old man will no longer have to grapple with the risk of outliving his savings, as the annuity payments are guaranteed, even if he does live to see 90, 95, or even 100 years of age.

The disadvantage is that an income annuity pays a fixed amount of income. Over time, inflation will slowly eat away at the value of the monthly payment you receive, making them less attractive for younger retirees. Assuming an inflation rate of 3%, an annuity payment will be worth about 26% less after 10 years and roughly 45% less after 20 years. Variable annuities, which provide for annual payouts that vary with the performance of stocks, for example, offer much better protection against inflation.

Finally, one very big risk is to your heirs. Unless you specifically buy an income annuity that provides for a "certain option," which guarantees a minimum number of payments, the annuity will stop providing income upon death. Thus, it's quite possible for someone to buy an annuity, collect only a fraction of their initial investment, and die before the remaining payments are made.

The article Income Annuity: Pros and Cons of Predictable Income originally appeared on Fool.com.

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